Flow of funds

The flow of funds (or financial account) is a system of accounting that records all finan- cial transactions of an economy. Bookkeeping both the financial stocks and flows, it tracks the sources and uses of funds for each institutional sector and for the economy as a whole. The flow of funds is one of the key instruments in national accounting together with the national income and product account, the national balance sheet, and the input- output matrix. It is one of the primary components of the System of National Accounts (SNA) of the United Nations. First published in 1953, the flow of funds was incorpo- rated within the SNA in 1968.

The flow-of-funds approach stems from the work of Morris Copeland, an American institutionalist economist who worked at the US Federal Reserve. The intuition of Copeland was to enlarge the social accounting perspective (which had been until then used mainly in the study of national income) to the study of money flows. Hence, with his attempts to find answers to fundamental economic questions such as "when total purchases of our national product increase, where does the money come from to finance them" and "when purchases of our national product decline, what becomes of the money that is not spent", he laid the foundation of this accounting approach (Copeland, 1949,p. 254). A concrete example of his legacy is represented by the quadruple-entry system.

Since one sector's inflow is another sector's outflow, the standard double-entry principle applied at an aggregated level doubles into a quadruple-entry system.

The work of Copeland was immediately capitalized by the US Federal Reserve System, which in 1951 started publishing its "money flows", whose name was changed in 1955 to "flow of funds" (Vanoli, 2005). The diffusion of this innovation was prompt (as it was adopted in 1958 by the Bank of Japan and in 1959 by the Reserve Bank of India) and continues to this day (for instance, it was adopted by Brazil in 1985, by China in 1986, and by the euro area in 2001).

While the work of Copeland had tremendous implications for statisticians and public institutions such as central banks and national statistical offices, the usage of the gen- erated data to elaborate on economic theory was rather scarce within the academic community. As noted by Cohen (1972), the potential disruptive impact on the study and modelling of the interdependences between real and financial flows failed to occur. Cohen (ibid., p. 13) points to "the lack of a so-called 'organizing theory'" as one of the possible causes of such a drawback. Dawson (1996, p. 89) blames the direction along which economic theory has evolved: "a new kind of division of labor seems to have developed between those who seek to make empirical forecasts of aggregate economic activity and those who seek to build neat, deterministic macromodels in which economic behavior is specified in terms of utility and profit maximization [. . .]. These latter models tend to be more concerned with Walras's Law than with social accounting equations". This different focus (which appears at best myopic in light of the global financial crisis that occurred in 2008-09) finds its justification in the Modigliani-Miller (1958) theorem, as it basically negates part of Copeland's work.

There are, however, a few notable exceptions of authors elaborating models on stocks and flows. For example, Denizet (1967) based his analysis on a framework similar to the post-Keynesian stock-and-flows consistent methodological approach, which provides "a transactions flow matrix that has implicitly all the features of the matrices that were later produced explicitly by Tobin [. . .] and systematically by Godley" (Lavoie, 2014, p. 4). Turnovsky (1977) tried to include financial markets in the standard IS-LM framework, expanding the work of previous authors, such as May (1970) on continuous and discrete time in the analysis of stocks and flows, and Meyer (1975) on the coherence between stocks and flows ("conservation principle").

In the 1980s, two economists started using the flow-of-funds data with a theoretical purpose. On the one hand, James Tobin (see notably Backus et al., 1980; Tobin, 1982) concentrated his analysis on the portfolio choice of households and in doing so high- lighted feedbacks between financial and real flows. On the other hand, Wynne Godley focused more broadly on national accounts. Not only did he manage to observe trouble- some dynamics (see Godley, 1999) but he also developed a branch of models that inte- grated stocks and flows in a consistent manner (see Godley and Cripps, 1983).

The fact is that, notwithstanding Tobin and Godley's work, the flow-of-funds approach to economic modelling remained (and is still) marginal within economic lit- erature. The financial and economic crisis that occurred in 2008-09, however, has shed light again on the financial sector, inducing some central banks to look again at the information contained in the flow of funds (see Bê Duc and Le Breton, 2009; Barwell and Burrows, 2011).

See also:

Federal Reserve System; Financial crisis; Modigliani-Miller theorem.